Why Fortune 500 Employees Should Know About Retained Interest Transfers

What Is a Retained Interest?

A Split Interest in Property

Many of our Fortune 500 clients continually inquire about retained interest. A retained interest (also known as an actuarial interest) is an interest in property retained by the grantor (also known as the transferor or donor) upon the transfer of property during the grantor's lifespan. When a property is divided into two interests, one interest is the life or term interest (both referred to here as term interests because that is how the IRS refers to them), and the other is the remainder interest. The retained interest may be either the term interest or the remainder interest.

This form of property ownership can also be arranged for properties that are acquired in conjunction with a third party. This is known as a split-interest acquisition. One buyer holds the term interest, while the other holds the remainder interest.

Here's an example of a retained term interest for our clients from Fortune 500: Assume you transfer your home to your children, but retain an interest that allows you to continue living there for the remainder of your life. Your offspring will inherit the home after your passing. Your retained interest in the property is known as a life estate. Your offspring hold the remaining interest in the property. They are known as the remaining individuals.

Here is an example of a retained remainder interest for Fortune 500 employees: Consider a transfer of $500,000 to a trust. For ten years, your offspring will receive an income stream from the trust, after which the principal will revert to you. In this instance, your offspring receive the term interest, whereas you retain the remainder interest, or, more precisely, the interest.

We'd also like to provide Fortune 500 employees with an example of a split-interest purchase: Assume that you and your son jointly purchase an apartment building. You retain the right to receive the apartment building's rental income for five years. Your son owns the building's remainder interest.

After five years, your son has the option to either continue receiving the income or transmit ownership of the property. In these forms of property ownership arrangements, the parties' interests in the property are divided (grantor and beneficiaries or co-buyers). The interests are entirely distinct. Each interest may be encumbered, assigned, bestowed, sold (with the consent of all co-owners), or acquired by one or more parties.

Moreover, every interest has its own value. The values are determined using Treasury-issued actuarial tables and are based on the valuation of the property, the current interest rate, the length of time each interest has been owned, and mortality factors. The value of each interest is crucial because it determines any transfer taxes that may apply as well as the purchase price that co-buyers must pay in a split-interest purchase. In addition, for transfer tax purposes, certain categories of retained interests using trusts (as they are referred to by the IRS) are treated differently. This discussion is solely a summary of a highly complex legal field involving numerous fact-specific determinations. Regarding their particular circumstances, Fortune 500 employees should consult a tax expert.

Once Used to Avoid Transfer Taxes

It's important for Fortune 500 employees to be aware that retained interest transfers, which were previously used as a strategy to avoid transfer taxes, have been subject to changes in tax regulations. The IRS enacted Section 2702 in 1990 to close the loophole for such transfers. Under this rule, if a donor transfers property to a family member while retaining an interest in the property, the donor is considered to have transferred the entire property for gift tax purposes. This means that the value of the retained interest is disregarded, and the donor is taxed on the full value of the property at the time of transfer. Therefore, it's crucial for Fortune 500 employees to consult with tax professionals to understand the current tax implications of retained interest transfers and to plan their estate and gift strategies accordingly.

Prior to 1990, it was common practice to avoid transfer taxes by structuring a property transfer as a retained interest transfer. We would like to demonstrate to our Fortune 500 patrons how this worked:

Example(s): Fred transfers $2 million worth of property to a trust. He receives a lifetime income from the trust, and upon his death, the principal is transferred to his offspring. The retained interest of Fred is worth $800,000. Fred does not pay any gift tax on this amount. Fred only pays gift tax on $1.2 million ($2 million - $800,000), assuming no other variables. Fred's estate may include the retained interest upon his demise. At that moment, however, the retained interest is only worth $500,000. Fred saves $300,000 in taxes ($800,000 - $500,000).

How Does the IRS Treat Certain Retained Interests Today?

General Rule

Enacting Section 2702 in 1990, Congress closed the loophole for so-called. This rule generally states that if a donor transfers property to a family member while retaining an interest in the transferred property, the donor is considered to have transferred the entire property. Specifically, the rule specifies that the value of the retained interest is disregarded for gift tax purposes if: (1) the grantor transfers property to a trust, (2) any beneficiary of the trust is a, and (3) the grantor retains an interest. In other words, Fred is taxed on the entire $2 million when the trust is established, irrespective of the value of the retained interest.

A encompasses a transfer to a new or existing trust as well as an interest assignment to an existing trust. Consequently, a lapse in withdrawal authority may qualify as an under this rule. A may also include the purchase of property by two or more family members with divided interests. In such situations, the party acquiring the term interest is considered to have acquired the entire property and then transferred the remainder of the interest to the remaining party or parties.

A comprises the spouse of the grantor, any ancestor or lineal descendant of the grantor or the grantor's spouse, any sibling of the grantor, and any spouses of such ancestors, descendants, and siblings. An encompasses the grantor's spouse, the grantor and grantor's spouse's ancestors, and the ancestors' spouses.

A can be a life or term interest, a remainder or reversionary interest, or a power of appointment. Gary, for instance, transfers property to a trust and retains the power to designate the income's beneficiaries for ten years. Gary is deemed to have retained an interest in the trust because the IRS views this arrangement as if Gary had retained a right to the income and then distributed it to the beneficiaries. However, rights in the trust held by a legitimate creditor are not an. Consequently, a right to receive compensation from the trust pursuant to a legitimate note, lease, or employment contract is not a retained interest.

Exceptions

The IRS refers to the following retained interests as exceptions to the general rule because the donor does not retain rights that can impact the value of the transferred interests:

•  Following an inadequate gift, interests are retained.
•  Term income interests in particular tangible assets.
•  A portion of a qualified annuity.
•  Participation in a unitrust.
•  Contingent remainder interests following an annuity.
•  Unconditional remainder interests following a unitrust.
•  Donor-retained remainder interests in a charitable remainder trust.
•  The beneficiaries of a charitable lead trust.
•  Participation in a pooled-income fund.
•  Certain income-qualifying interests in personal residences.
•  Interests as a permissible recipient of income distribution that are solely at the trustee's discretion.
•  Interests retained by a spouse in a trust created for the other spouse if the transfer is deemed to be for full and adequate consideration under section 2516.
•  Retained interests following certain transfers to a qualified domestic trust.
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Each of these exceptions is fairly limited and has distinct tax ramifications, so Fortune 500 employees should consult a tax professional to determine how to structure a gift optimally.

How Does the IRS Treat a Subsequent Transfer of a Retained Interest Valued Under Section 2702?

Inter Vivos Transfers

If you retain an interest that is valued under the general rule of Section 2702 and then transfer that interest to another party, no gift taxes are imposed on the subsequent transfer. This is accomplished by reducing the amount you earned during the subsequent calendar year in which the transfer occurs.

The reduction is the lesser of (1) the increase in your taxable gifts caused by the valuation ascribed to the remainder interest at the time of the initial transfer, or (2) the increase in your taxable gifts caused by the subsequent transfer of the interest. This means that the reduction is equal to the lesser of the value of the interest at the time it is retained or at the time it is subsequently transferred. The result is that no additional transfer taxes are due, but if the value of the interest declines, you do not actually save transfer taxes.

Example(s): Assume that eight years ago, you transferred $2 million to a trust. Your parents are entitled to income from the trust for ten years, after which the principal is returned to you. Your retained interest was estimated to be worth $1,200,000. However, under Section 2702, the complete $2 million was subject to gift tax (assuming no other variables). This year, you give your offspring your retained interest and make other gifts totaling $50,000. Assume that the retained interest's current value is $1 million. Before reduction, your adjusted taxable gifts for this year are $1,050,000. Due to the fact that the retained interest was treated in accordance with the general rule of Section 2702, you are entitled to a reduction of your adjusted taxable gifts equal to the lesser of the value of the interest at the time it was retained ($1.2 million) or the value of the interest now ($1 million). Thus, you are entitled to a $1 million reduction. The adjusted value of your taxable gifts for the current year is $50,000.

Testamentary Transfers

If a retained interest in a trust is included in the decedent's aggregate estate and the interest was previously valued under Section 2702, the decedent's adjusted taxable gifts are reduced. The same valuation principles that govern subsequent inter vivos transfers also govern testamentary transfers.

Retained Interest can be likened to a grand estate that you have built over the years, where you still maintain certain rights and privileges while planning its future ownership. Imagine yourself as the builder and owner of a magnificent mansion. As the grantor, you decide to transfer the property to your children, but you retain the right to live in the mansion for the rest of your life. This retained interest is similar to having a life estate in the property. Your children, as the remainder individuals, will inherit the mansion after your passing. Just like the mansion, the value of the retained interest is assessed, and the tax implications are determined based on this arrangement. It's crucial to understand the rules and regulations surrounding retained interest transfers, much like maintaining the grandeur and legacy of your estate requires careful planning and attention to detail. Consulting with experts in estate planning and tax professionals will help ensure a smooth transition and protection of your valuable assets.

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of  The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

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